Learn to invest with Buffett

Chapter 32

Chapter 5 Section 4 Book profits: Don’t trust everything
I believe I could have saved $1 million in losses if I had shut down General Re's securities division immediately.Munger and I hated the securities department when we bought General Re, but the earnings figures on the books deceived us.While we believe this sector is extremely risky, we cannot effectively measure or limit it.Even, we also know that once the department has a major problem, whether it is financial or insurance, it will have some impact on other Berkshire operations.

--Warren Buffett
Buffett believes that operating performance is an important indicator of a company, but investors must understand one thing: book profits and actual profits are sometimes not the same.Generally speaking, only the company itself knows the ins and outs of the book profit of the company, and investors have no idea how the book profit is calculated, so investors must not be confused by the book profit.

Sometimes book profits are not real profits.When Buffett acquired General Re, he felt that there were some problems with General Re's securities department.Both he and his partner Charlie Munger felt that this department was too risky and prone to some major problems, but the securities department was profitable on the books, and the profit was not low.It is this kind of book profit that confuses Buffett's judgment, making Buffett fail to close the securities department in time, causing a lot of losses to Berkshire.The reason why General Re's securities department suffered losses was, in the final analysis, the fault of financial derivatives. At the beginning of 2002, Berkshire began to liquidate the securities department and found that there were 23218 contracts in circulation in this department, with as many as 884 trading partners.And many of these contracts and transaction partners are very unfamiliar, and they have never even heard of them, and it is impossible to talk about credit evaluation.After two years of cleaning, it is still not completely cleaned up.The cost of cleaning up the securities department is as high as 2.6 million US dollars. If many financial derivatives cannot be cashed, the loss will be even greater.

Buffett believes that investors should not be happy just seeing high book profits.Every industry and every business is different.Due to the high risk in certain industries, the book profits of companies in this industry are likely to be a huge positive number at this moment, and become a huge negative number at the next moment.For example, the reinsurance industry is such an industry where risks exist all the time. In 2001, the "911" terrorist attack occurred in the United States, and all reinsurers paid a total of US$350 billion in claims. In 1992, when Hurricane Andrew hit, all reinsurers paid a total of $155 billion in claims.No one can predict the future.Therefore, in the next 20 years, if any catastrophe occurs, it is entirely possible that reinsurance companies will need to pay as much as US$1000 billion in claims.Once such a catastrophe occurs, almost all reinsurance companies will lose money that year, and some reinsurance companies may even close down or go bankrupt due to poor capital turnover.

Investment motto:

Book profit and actual profit are not exactly the same.Investors must keep their eyes open, carefully analyze the book profits of enterprises, and not be deceived by the huge data of book profits.

(End of this chapter)